Preferred Stock Umbrellas . . .

refer to a common form of venture capital financing in which the investors are issued convertible preferred stock while management and founding shareholders hold common stock. The structure is frequently used when management receives its shares at or about the same time as the outside investors.

The existence of the umbrella establishes an argument that the stock purchased by the investors is worth more per share than that held by management. The need to create this argument arises whenever management shareholders pay less per share for their stock than do the outside investors in transactions that are contemporaneous or nearly contemporaneous. When they do, the IRS may treat the difference in share prices as "hidden income" to management and tax management on the amount of that difference times the number of shares purchased by them at the lower price. (If charged to the management shareholder, this hidden income may be deductible by the company if it withholds taxes from other payments to the shareholder.)

To try to avoid this result, management can add value to the shares the outside investors purchase by granting them preference rights over the common stock. Commonly, these preferences include the right to receive dividends before holders of common stock and the right to receive distributions on liquidation of the company before any is made to the holders of common stock. Further preferences and rights can be created to add value to the securities being purchased by the outside investors. To the extent additional value is given to the shares purchased by the outside investor, management can reasonably contend that a lower price per share is justified for their common shares. If this argument is successful, management can reduce or eliminate the risk of hidden taxable income.

Another way to reduce the likelihood of hidden income is to have management purchase their shares long before the investors buy their shares. The longer the period of time between the two purchases, the easier it is to argue that the company’s stock was worth less when purchased. Neither the preferred stock umbrella nor the passage of time between purchases, however, can guarantee that management shareholders will not be taxed on hidden income - they only reduce the likelihood of being taxed and, then, only to the extent they create distinctions that reflect real differences in value.

Structuring a financing so that outsider investors receive preferred stock while insiders receive common stock can also make it easier for management to use common stock to attract and retain key personnel. This is because shares issued to employees must be issued at their fair market value, or the IRS may claim that the recipient must pay taxes on the difference between the fair market value of the stock and the purchase price. If only one class of stock has been issued, that fair market value will be equal to or more than the price per share paid by the outside investors (unless the company’s per share value has decreased since the financing). If little time has transpired since the venture capital financing or the company is growing or becoming more profitable, a lower valuation is unlikely. In other words, the issue price of the shares used to attract a new key employee will probably have to be as high or higher than the price paid by the venture investors.

If, instead, the outside investors purchase preferred stock, the company may be justified in issuing common stock to the new employee at a price that is lower than that paid by the venture investor because the common shares issued to the employee have fewer rights than the preferred shares. This, in turn, can make it easier for the new employee to purchase the shares and make the purchase more attractive. The justifiable difference in prices, of course, depends on a real difference between the value of the preferred shares and the common shares.

Preferred stock umbrellas should not be used for tax reasons without carefully weighing the cost to the company. This cost is the increased value given to the outside investors for their investment in order to improve management’s argument that its shares were purchased at fair market value. The benefit to management in avoiding being taxed on hidden income or in being able to issue cheaper stock to new employees may or may not be real, depending on the findings of the IRS. (Other methods such as earnups, puts, incentive stock options, stage financings, and unit offerings can be used to avoid potential hidden income problems.)

As a practical matter, however, many venture investors will insist on acquiring preferred stock as a condition to funding. One of the most common venture investment vehicles is the convertible, redeemable preferred stock instrument. Because complex issues are raised by issuing preferred stock, management shareholders should review their situation carefully with experienced legal counsel before proceeding. See: Convertible Preferred Stock, Convertible Securities, ISOs (Incentive Stock Options), K.I.S.S., Participating Preferred Stock, Preferred Stock, Pricing, Unit Offerings.